AP Macroeconomics – Mr. Logan’s Class Page 1 of 7
ANSWERS TO END-OF-CHAPTER QUESTIONS
11-1 Why is the aggregate demand curve downsloping? Specify how your explanation differs from the
explanation for the downsloping demand curve for a single product. What role does the
multiplier play in shifts of the aggregate demand curve?
The aggregate demand (AD) curve shows that as the price level drops, purchases of real domestic
output increase. The AD curve slopes downward for three reasons. The first is the interest-rate
effect. We assume the supply of money to be fixed. When the price level increases, more money
is needed to make purchases and pay for inputs. With the money supply fixed, the increased
demand for it will drive up its price, the rate of interest. These higher rates will decrease the
buying of goods with borrowed money, thus decreasing the amount of real output demanded.
The second reason is the real balances effect. As the price level rises, the real value,—the
purchasing power—of money and other accumulated financial assets (bonds, for instance) – will
decrease. People will therefore become poorer in real terms and decrease the quantity demanded
of real output.
The third reason is the foreign purchases effect. As the United States’ price level rises relative to
other countries, Americans will buy more abroad in preference to their own output. At the same
time foreigners, finding American goods and services relatively more expensive, will decrease
their buying of American exports. Thus, with increased imports and decreased exports, American
net exports decrease and so, therefore, does the quantity demanded of American real output.
These reasons for the downsloping AD curve have nothing to do with the reasons for the
downsloping single-product demand curve. In the case of the dropping price of a single product,
the consumer with a constant money income substitutes more of the now relatively cheaper
product for those whose prices have not changed. Also, the consumer has become richer in real
terms, because of the lower price of the one product, and can buy more of it and all other
products. But with the AD curve, moving down the curve means all prices are dropping—the
price level is dropping. Therefore, the single-product substitution effect does not apply. Also,
whereas when dealing with the demand for a single product the consumer’s income is assumed to
be fixed, the AD curve specifically excludes this assumption. Movement down the AD curve
indicates lower prices but, with regard to the circular flow of economic activity, it also indicates
lower incomes. If prices are dropping, so must the receipts or revenues or incomes of the sellers.
Thus, a decline in the price level does not necessarily imply an increase in the nominal income of
the economy as a whole.
The multiplier acts on an “initial change in spending” to generate an even greater shift in the
aggregate demand curve. (Figure 11-2)
11-2 Distinguish between “real-balances effect” and “wealth effect,” as the terms are used in this
chapter. How does each relate to the aggregate demand curve?
The “real balances effect” refers to the impact of price level on the purchasing power of asset
balances. If prices decline, the purchasing power of assets will rise, so spending at each income
level should rise because people’s assets are more valuable. The reverse outcome would occur at
higher price levels. The “real balances effect” is one explanation of the inverse relationship
between price level and quantity of expenditures.
The “wealth effect” assumes the price level is constant, but a change in consumer wealth causes a
shift in consumer spending; the aggregate expenditures curve will shift right. For example, the
value of stock market shares may rise and cause people to feel wealthier and spend more. A
stock decline can cause a decline in consumer spending.
11-3 Why is the long-run aggregate supply curve vertical? Explain the shape of the short-run
aggregate supply curve. Why is the short-run curve relatively flat to the left of the full
employment output and relatively steep to the right?
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The long-run aggregate supply curve is vertical (at the full-employment or potential output)
because the economy’s potential output is determined by the availability and productivity of real
resources, not by the price level. The availability and productivity of real resources is reflected in
the prices of inputs, and in the long run these input prices (including wages) adjust to match
changes in the price level. Firms have no incentive to increase production to take advantage of
higher prices if they simultaneously face equally higher resource prices.
The shape of the short-run supply curve is upward-sloping. Wages and other input prices adjust
more slowly than the price level, leaving room for firms to take advantage of these higher prices
(temporarily) by increasing output. Firms face increasing per unit production costs as they
increase output, making higher prices necessary to induce them to produce more.
To the left of full-employment output the curve is relatively flat because of the large amounts of
unused capacity and idle human resources. Under such conditions, per-unit production costs rise
slowly because of the relative abundance of available inputs. Additional resources are easily
brought into production, as the suppliers of these resources (especially labor) are eager to employ
them and are happy to accept current prices.
To the right of full-employment output the curve is relatively steep because most resources are
already employed. Those resources that are not yet in production require higher prices to induce
them, or generate higher per-unit production costs because they are less productive than currently
employed inputs. Firms trying to increase production bid up input prices as they attempt to
attract resources away from other firms. Even if the firm succeeds in pulling resources from
another firm, the aggregate increase in output is minimal at best, as resources are merely shifted
from one productive process to another.
11-4 (Key Question) Suppose that aggregate demand and supply for a hypothetical economy are as
Amount of Amount of
real domestic real domestic
output demanded, Price level output supplied,
billions (price index) billions
$100 300 $450
200 250 400
300 200 300
400 150 200
500 100 100
a. Use these sets of data to graph the aggregate demand and aggregate supply curves. What is
the equilibrium price level and the equilibrium level of real output in this hypothetical
economy? Is the equilibrium real output also necessarily the full-capacity real output?
b. Why will a price level of 150 not be an equilibrium price level in this economy? Why not
c. Suppose that buyers desire to purchase $200 billion of extra real domestic output at each
price level. Sketch in the new aggregate demand curve as AD1. What factors might cause
this change in aggregate demand? What is the new equilibrium price level and level of real
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(a) See the graph. Equilibrium price level = 200. Equilibrium real output = $300 billion. No,
the full-capacity level of GDP is more likely at $400 billion, where the AS curve starts to
(b) At a price level of 150, real GDP supplied is a maximum of $200 billion, less than the real
GDP demanded of $400 billion. The shortage of real output will drive the price level up. At
a price level of 250, real GDP supplied is $400 billion, which is more than the real GDP
demanded of $200 billion. The surplus of real output will drive down the price level.
Equilibrium occurs at the price level at which AS and AD intersect.
(c) See the graph. Increases in consumer, investment, government, or net export spending might
shift the AD curve rightward. New equilibrium price level = 250. New equilibrium GDP =
11-5 (Key Question) Suppose that a hypothetical economy has the following relationship between its
real output and the input quantities necessary for producing that level of output:
a. What is productivity in this economy?
b. What is the per-unit cost of production if the price of each input is $2?
c. Assume that the input price increases from $2 to $3 with no accompanying change in
productivity. What is the new per-unit cost of production? In what direction did the $1
increase in input price push the economy’s aggregate supply curve? What effect would this
shift in aggregate supply have upon the price level and the level of real output?
d. Suppose that the increase in input price does not occur but instead that productivity increases
by 100 percent. What would be the new per-unit cost of production? What effect would this
change in per unit production cost have on the aggregate supply curve? What effect would
this shift in aggregate supply have on the price level and the level of real output?
Input Real domestic
(a) Productivity = 2.67 (= 400/150; = 300/112.5; = 200/75.0)
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(b) Per-unit cost of production = $.75 (= $2 x 112.5/300)
(c) New per-unit production cost = $1.13 (= $3 x 75/200). The AS curve would shift leftward.
The price level would rise and real output would decrease.
(d) New per-unit cost of production = $0.375 (= $2 x 112.5/600). AS curve shifts to the right;
price level declines and real output increases.
11-6 (Key Question) What effects would each of the following have on aggregate demand or
aggregate supply? In each case use a diagram to show the expected effects on the equilibrium
price level and level of real output. Assume that all other things remain constant.
a. A widespread fear of depression on the part of consumers.
b. A $2 increase in the excise tax on a pack of cigarettes.
c. A reduction in interest rates at each price level.
d. A major increase in Federal spending for health care.
e. The expectation of rapid inflation.
f. The complete disintegration of OPEC, causing oil prices to fall by one-half.
g. A 10 percent reduction in personal income tax rates.
h. A sizable increase in labor productivity (with no change in nominal wages).
i. A 12 percent increase in nominal wages (with no change in productivity).
j. Depreciation in the international value of the dollar.
(a) AD curve left, output down, and price level down (assuming no ratchet effect).
(b) AS curve left, output down, and price level up.
(c) AD curve right, output and price level up.
(d) AD curve right, output and price level up (any real improvements in health care resulting
from the spending would eventually increase productivity and shift AS right).
(e) AD curve right, output and price level up.
(f) AS curve right, output up and price level down.
(g) AD curve right, output and price level up.
(h) AS curve right, output up and price level down.
(i) AS curve left, output down and price level up.
(j) AD curve right (increased net exports); AS curve left (higher input prices)
11-7 (Key Question) Other things equal, what effect will each of the following have on the
equilibrium price level and level of real output:
a. An increase in aggregate demand in the steep portion of the aggregate supply curve.
b. An increase in aggregate supply with no change in aggregate demand (assume that prices and
wages are flexible upward and downward).
c. Equal increases in aggregate demand and aggregate supply.
d. A reduction in aggregate demand in the flat portion of the aggregate supply curve.
e. An increase in aggregate demand and a decrease in aggregate supply.
(a) Price level rises rapidly and little change in real output.
(b) Price level drops and real output increases.
(c) Price level falls slowly and real output falls rapidly.
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(d) Price level does not change, but real output declines.
(e) Price level increases, but the change in real output is indeterminate.
11-8 Explain how an upward-sloping aggregate supply curve weakens the multiplier.
An upward sloping aggregate supply curve weakens the effect of the multiplier because any
increase in aggregate demand will have both a price and an output effect. For example, if
aggregate demand grows by $110 million, this could represent an increase of $100 million in real
output and $10 million in higher prices if the inflation rate averages 10 percent. The multiplier is
weakened because some of the increase in aggregate demand is absorbed by the higher prices and
real output does not change by the full extent of the change in aggregate demand.
11-9 Why does a reduction in aggregate demand reduce real output rather than the price level? Why
might a full-strength multiplier apply to a decrease in aggregate supply?
A reduction in aggregate demand causes a decline in real output rather than the price level
because prices are “sticky” or inflexible downward. If we assume prices are completely
inflexible downward, then a reduction in demand is essentially moving leftward and the aggregate
supply curve is flat (horizontal), which means reduced output at a constant price. To say prices
are completely inflexible downward may exaggerate, but prices don’t fall easily for several
reasons: wage contracts, minimum wage laws, employee morale, fear of price wars and the
“menu cost” notion.
Without price changes to mitigate the effects of an aggregate demand change, the multiplier is at
full strength. If price were flexible downward, the decrease in spending would lower prices,
encouraging some individuals within the macroeconomy to spend more, dampening the multiplier
11-10 Explain the statement: “Unemployment can be caused by a decrease of aggregate demand or a
decrease of aggregate supply.” In each case, specify price-level effects.
The statement is true, although the magnitude of the effect on unemployment can vary
considerably, particularly with decreases in aggregate demand. A decrease in aggregate supply
will unambiguously increase the price level and reduce real output. With the decrease in output
we would expect unemployment to rise. If the economy is operating above its full-employment
output, a decrease in aggregate demand will have more modest effects on unemployment, having
its strongest impact on the price level (reducing it). If aggregate demand falls while the economy
is operating to the left of full-employment output, the increases in unemployment will be more
substantial, and the effects on the price level weaker.
11-11 Use shifts in the AD and AS curves to explain (a) the U.S. experience of strong economic growth,
full employment, and price stability in the late 1990s and early 2000s; and (b) how a strong
negative wealth effect from, say, a precipitous drop in the stock market could cause a recession
even though productivity is surging.
(a) While AD is increasing and shifting to the right, AS is shifting rightward as well, because of
productivity increasing and a growing labor force. Thus, both output and employment can
rise while price level remains constant. The equilibrium shifts rightward, not upward because
AS and AD shift by similar magnitudes.
(b) In this situation AD shifts left while AS shifts right. Price level may even decline, but real
output could decline if the reduction in AD exceeds the increase is AS. Figure 11-10 shows
how this could happen even if AS shifted to the right.
11-12 In early 2001 investment spending sharply declined in the United States. In the 2 months
following the September 11, 2001, attacks on the United States, consumption also declined. Use
AD-AS analysis to show the two impacts on real GDP.
Both events would be represented by a leftward shift in aggregate demand, and the initial declines
in spending would be multiplied. (See Figure 11-2, shift from AD1 to AD3.) This would cause
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real GDP to drop and, assuming flexible prices, a drop in the price level. To the extent the drop
in investment spending affected productivity, it could have either shifted AS left (if productivity
dropped) or slowed the rightward movement of AS that occurred through much of the 1990s and
into the early 2000s.
11-13 (Last Word) State the alternative views on why unemployment in Europe has recently been so
high. What are the policy implications of each view?
There are two views on this question. One is that there is a high natural rate of unemployment in
each of the European countries in question. This view holds that there are high levels of frictional
and structural unemployment that accompany the full-employment level of output. Any increase
in aggregate demand would cause demand-pull inflation. The sources of the high frictional and
structural unemployment are government policies and union contracts, which increase the costs of
hiring and reduce the costs of not having a job. For example, there are high minimum wages;
generous welfare benefits; restrictions against firing, which discourage firms from employing
workers; thirty to forty days of paid vacation per year; high worker absenteeism, which reduces
productivity; and high employer costs of health, pension, disability, and other benefits.
The second explanation disagrees with the first and sees the major problem as being deficient
aggregate demand. Those economists who hold this view point to government policies that are
aimed at preventing inflation and not at increasing aggregate demand. In this view, the European
economies are operating in the flatter area of their aggregate supply curves and, increases in
aggregate demand would not be inflationary but would, instead, increase output and employment.
Chapter 11 Appendix
11-1 Explain carefully the statement: “A change in the price level shifts the aggregate expenditures
curve but not the aggregate demand curve.”
A change in the price level simply represents a movement along the curve, because there is an
inverse relationship between the price level and aggregate quantity demanded.
However, a change in the price level will shift the aggregate expenditures curve, which responds
to the wealth, interest-rate, and foreign purchases effects occurring with a change in price level.
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When the price level declines, aggregate expenditures will rise, and when the price level rises,
aggregate expenditures will fall. The aggregate expenditures model assumes a constant price
level, so it is expressed in “real” terms. Appendix Figures 11-1 and 11-2 graphically illustrates
the relationship between the two models.
11-2 Suppose that the price level is constant and investment spending decreases sharply. How would
you show this decrease in the aggregate expenditures model? What would be the outcome for
real GDP? How would you show this fall in investment in the aggregate demand-aggregate
supply model, assuming the economy is operating in what, in effect, is a horizontal range of the
aggregate supply curve?
A decrease in investment spending represents a decrease in aggregate expenditures and a
downward shift in the aggregate expenditures curve. The outcome would be a new, lower
equilibrium output level. This fall in output would be equal to a multiple of the initial change in
investment spending based on the multiplier effect. The multiplier is 1/MPS in this model.
It would be a leftward shift of aggregate demand, and the new equilibrium output would fall to
the left of the original equilibrium by the full extent of the shift in aggregate demand. The price
level (assumed by using the AE model) will not change. See figure below.
Appendix Question 11-2